Since last week, Mumbai resident Rajendra Doshi has been buying four or five shares of

Infosys Technologies daily. For, last week, the information technology services firm
announced a 1:1 bonus issue. The company has not fixed a record date for the issue
and Doshi aims to own at least 100 shares by the time one is announced.
Many savvy investors do likewise to make the most of public issues like a bonus or
rights issue. The main advantage is a tax benefit. Due to a loophole, bonus stripping
only in mutual fund schemes (not stocks) comes under the purview of Section 94 of the
Income Tax Act, 1961. It says an investor should have bought units of a scheme at least
three months prior to a bonus and stayed invested for at least six months.
Sometime earlier, JM Financial Mutual Fund's Arbitrage Advantage Fund had collected
Rs 5,000 crore (half of the MF inflows in July 2014) on the back of two types
of tax benefit. The first was that after the Budget announcement change in tax treatment
for debt funds. As a result, arbitrage funds came across as a better alternative, since
gains from it were exempt from tax as it is an equity fund. Union Budget 2014 raised
long-term capital tax on all debt funds to 20 per cent after three years. Earlier, withdrawal
from debt funds attracted a long-term capital gains tax of either 10 per cent (without
indexation) or 20 per cent (with indexation), whichever was lower, after one year.
Second, JM Arbitrage Advantage seems to have informally promised a tax benefit on
bonus stripping, though the management denied it.
The practice of buying stocks or mutual fund units to take part in a bonus issue, which
allows them to book losses on the original investment value and then set it off is called
bonus stripping. There can be two ways in which investors can take advantage of bonus
stripping from a tax point of view, says Vaibhav Sankla, director of tax consultancy firm
H&R Block.
Scenario 1
Assume an individual has been holding Infosys stocks for some time and the stocks are
worth Rs 1 lakh today; he has bought it for say Rs 500 then. As the stock's current
market price (CMP) is around Rs 4,000, the investor holds approximately 25 shares.
He would sell all the 25 shares at the CMP of Rs 4,000 each. Since the gains are long
term in nature, the same would be tax exempt. Simultaneously, he would also purchase
25 shares at Rs 4,000 each. Both these transactions would be delivery based. These
are carried out to provide a new 'cost basis' of Rs 4,000 as against Rs 500 and make the
shares 'short term', explains Sankla.
As Infosys has announced a 1:1 bonus issue, the investor will get another 25 shares on
the record date. Under the tax laws, the cost of the bonus shares is considered as zero.
On the ex-bonus date, that is the day after the bonus is distributed, the investor will own
50 shares costing Rs 2,000 each at the CMP.
If the investor sells half his holding ex-bonus (25 shares), at the CMP of Rs 2,000 each,
he will book a capital loss of 50 per cent. This is so because he will earn Rs 50,000 as
against his original cost of Rs 1 lakh. Tax loss = Rs 50,000. This loss of 50 per cent can

be set off against any other long-term or short-term capital gains, adds Sankla. If you
cannot set off the entire loss booked in one financial year, you can do so over the next
seven.
Say the investor wants to maintain his portfolio holding. He can again buy as many
shares he sold to book profit. If all these shares are sold after a year, the entire gains
from the sale would be tax exempt. The disadvantage: You will incur a transaction cost,
though that will be lot less than the tax advantage you get. Tax experts warn that
sometimes the tax department could question if they notice shares sold in a year only to
book a capital loss and adjust capital gains.
Scenario 2
Assume Doshi was sitting on short-term capital gains of Rs 50 lakh from the sale of a
property. Short-term capital gains from sale of property cannot be deployed in another
property or capital gains bonds. Such capital gains are added to income and taxed at the
slab rate. Or, can be set off against other capital gains.
Assume Doshi buys Infosys shares worth Rs 1 crore before bonus shares are allotted. At
a CMP of Rs 4,000, he will own 2,500 shares. Say he sells half his share holding (of
5,000 shares) ex-bonus. Again, as his cost of acquisition was Rs 1 crore, he will book
a capital loss of 50 per cent as he will earn only Rs 50 lakh (2,500 x Rs 2,000) from this
share sale. Doshi can sell the balance shares only after a year for tax exemption.
Given Doshi's owning equities, he can be worried that the price of his remaining holding
could fall over the next year. If he doesn't want to take the risk, he will hedge the
holdings in the futures market for one year. A year from the allotment of bonus shares,
he shall sell the remaining (bonus) shares, free of tax. He can also liquidate his futures
position. However, he would be required to pay tax on gains from the futures holding at
30 per cent, says Sankla.
However, the tax and associated transaction cost would be much less than
the tax savings on the capital losses booked. If the stock market value of the stock falls
10 per cent, the gain on the derivative side, the investor will pay 30 per cent of 10 per
cent. Or, pay three per cent of the total holding. By the end of this month, Doshi could
buy the November futures as on the last Thursday of a month, futures prices converge
with the CMP, diluting the premium. The share futures price will not be exactly Rs 2,000
but at a premium of, say, Rs 200-300.
Caution
"Therefore, investors should always check the historic premium of stock futures. And,
should not take a position in stock futures with very significant premium," says Manoj
Nagpal, chief executive of Outlook Asia Wealth Advisors.
Bonus strippers mostly hedge their position through derivatives and, hence, should be
careful about liquidity in the derivatives market. This could be a problem when there are
a large number of bonus issues, adds Nagpal.
G Chokkalingam, managing director of Equinomics Research & Advisory, says investors
tend to make money or accumulate wealth ex-bonus/ex-rights only if the company or

fund house grows in tandem. "Some companies announce a bonus issue only to support
their market cap and investors lose money," he says. Three years earlier, he recalls, the
Sundaram Finance stock was priced at Rs 500. It announced a 1:1 bonus over a year
earlier and the stock quoted at Rs 1,270 ex-bonus. This means the stock went up 2,500
times. Similarly, eight months earlier, LG Balakrishna Brothers was at Rs 250-260. Three
to four months earlier, it announced a 1:1 bonus and the stock moved up to Rs 640 or
grew 1,200 times.
Going forward
Tax experts say if the General Anti Avoidance Rule comes into effect, the deadline for
which is April 1, 2015, bonus strippers could be pulled up. The law says if any
transactions does not have any commercial substance but results in lower tax, then
the tax department can cancel the benefit and recalculate the tax. However, the
threshold for this rule is tax benefit of Rs 5 crore or more.